The Train Is Leaving The Station
Having begun my career in Wall St investment banking nearly 50 years ago, I have lived through all of the various cycles, crises, and collapses. Just as Reinhart and Rogoff demonstrate in their tome, “This Time Is Different”, the reality is, things never really change, even over the 800 years they studied. Whether it was the S&L crisis, the Russian debt crisis, Mexican peso, 21% interest rates in 1981, the bankruptcy of New York, the dot com bubble burst, or the Great Recession, I have witnessed it all, and yet the cycle goes on. It is simply the degree of severity to the downturn that changes, and the policies that claim to fix the situation, but in the end, policy makers, and capital markets players, repeat the same mistakes. The politicians pull out the populist rhetoric, and they all say they will fix things, they care about the common man, the capitalist pigs stole the money, bailouts are unfair, or we need more regulation. By the way, there have been many bailouts of various industries over the decades. The banks were not the first.
After every crisis in the capital markets we have a virtual shut off of capital flows for deals, then it comes back slowly and with very tough underwriting. Spreads are wide at first as the risk taking lenders charge very wide spreads, such as Nomura did in 1993-1994 when they were the first to reenter the real estate lending market with securitized lending. I was directly involved in a JV with them as we started to the first hotel securitized lending platform, so I know that they were often able to make a 10 point profit at the start. Since there was no other money, and very few people understood securitization, there was also a dearth of knowledge which permitted margins to be extraordinary. As with everything else, there were soon competitors like Lehman and then others, and in time, spreads came in materially, Over time it became a commodity business and lenders were working for barely more than 1%. Up front points went away, spreads came in, proceeds went up, underwriting discipline disappeared, and then came mezz lending to fill that gap between what was lower proceeds and the borrowers wanting the lender to take more of the risk. As competition heated up further, CDO’s were created, and by then, all discipline went away. By 2007, you did not even need cash flow, proforma income was good enough, phony appraisals were standard procedure to pump up alleged values to justify more proceeds, and the beat went on until the inevitable crash. The train built up so much speed that nobody could stop it, and it simply went off the cliff in a classic Thelma and Louise last act.
In November 1993, in a conversation with a Nomura banker on the securitization floor of Nomura, we discussed how many years before the train crashed. We speculated on 10-12 years based on our own experience, and we predicted that this time it would wipe out all of the jobs of the bright smiley kids sitting at the desks in front of us. It was not that we were smart. We had simply seen it all before. In May 2007, I had lunch with 5 prominent players in the capital markets for real estate, and we all were discussing which week the start point of the inevitable crash would come and the degree of devastation. We picked last week in July as the start of the downturn, and total devastation as the end result. Again, it was not that we were so smart, but rather that we were all senior in the business and had seen it all before. Greenspan still runs around saying nobody knew. What bull. Most all of us out of diapers knew. If someone had been around the capital markets for 20 years or more and did not know, they had their head attached wrong.
So now we are in 2013. The politicians ranted and raved on TV, held absurd televised hearings with Carl Levin trying to look angry by reading slightly off color language, and in the end they passed Dodd Frank in a rush to judgment without ever really understanding what they wrote and voted for. Just the same as was done in 1933 and 1934, it is not that better regulation was not required, it was. However, when Barney Frank, who has more responsibility for the crisis happening than most, he who refused to reform Fannie in 2002, and who started the subprime problem by demanding banks make many more subprime loans to people who banks had refused to loan to as poor credit risks, and, Chris Dodd, who took a corrupt payoff in the form of a special home mortgage from Countrywide, were the authors, the outcome was destined to be bad. There is rarely a crisis that Congress does not rush to act without understanding what they legislated. For them it is all about looking aggressive and populist, even when what they do is bad law. Like Pelosi’s reasoning on Obamacare- “we need to pass it to know what is in it.” The all time classic statement.
So now we have gone through the stopping of the markets in 2008. Then the very slow recovery, and a few lenders who saw the opportunity to make wide spreads slowly coming back in. And now, just as we saw in 1994, the other lenders see their market share going away, their staff defecting, and their profits eroding, so they jump back in. Underwriting is tight at first. Spreads are wide at first. Now we already see lots of securitized and non- securitized lenders back. Conduit loans are already back to being commodities bid against each other. Spreads are in materially. Debt yields are reduced. Underwriting has stayed reasonably tight, but now there are already indications that it is starting to erode a bit. Proceeds are creeping up. Where in 1993 it took quite awhile to get active mezz programs going, there are already several active mezz lenders with plenty of money, and pressure to get it out because it was raised as a fund. Just since January 1, spreads on mezz are in 100 basis points to 8%-9%. Proceeds are 85% to even 90% in one case. There already is even the start of cash out loans. Covenants are already starting to soften. All the things that took years to happen in the nineties, are now starting to happen. CDO’s are starting up again, even though most thought they were dead forever. I am even hearing a few mezz lenders talk about starting to do construction mezz before the year is out. This is exactly how it all unfolded after the S&L crisis, and again in 1993 and onward. The steps are exactly the same.
Even with all the new regulations, more scrutiny, more lenders with awful memories, it is starting again. After five years of no action, the animals are hungry and need to be fed. The same statements are being made-- this time is different, we know how to be careful. O yeah- I have heard that all before, in each cycle, and it is all BS.
The train has left the station again, and Thelma and Louise are calling from the bottom of the cliff. It may take 7-12 years this time, but it will happen again, no matter what regs they write. As Reinhart and Rogoff proved, there is never a This Time Is Different. Only the faces change. It is human nature to try to find a way to do more volume and beat the competition, no matter the business or even between countries, and in the end the bubble bursts. Just remember this time to jump off the train before it goes off the cliff. You may get bruised, but you won’t get killed.